Charles Prideaux examines how a judicious combination of scale and tailoring can help institutional investors meet the specific outcomes they need
Traditionally, the asset management industry has struggled to make scale work for clients. All too often, attempts to introduce economies of scale have reduced flexibility, impaired performance and undermined managers' ability to provide a responsive service. No wonder, therefore, that, until recently, most institutional investors had an ambivalent attitude to the concept of scale. They were attracted by the potential cost benefits but wary of dilution of performance and loss of personalised service due to a rigid, one-size-fits-all implementation. Yet, while being able to reap the benefits of scale was a desirable goal prior to 2008, it has become a crucial one since.
Essentially, we have moved into a new world where significant volatility is part of everyday reality and institutional investors face formidable funding challenges exacerbated by regulatory constraints such as mark-to-market accounting or Solvency II. As a result, achieving optimum efficiency has moved to the top of institutional investors' agenda.
This quest for greater efficiency applies on both sides of the balance sheet: many institutional investors are having to de-risk, but need to do so in a way that minimises the amount of capital tied up, while on the asset side they seek to maximise the effectiveness of their available capital, fee and risk budgets in order to close funding gaps. At the same time, regulation and the decline in defined benefit (DB) pension provision have focused investors' minds on the specific end goals they seek to achieve. This, in turn, means that investors require genuinely tailored solutions. So how can scale assist asset managers meeting these different goals?
Probably the most tangible advantage of critical mass is the diversity of specialist tools that a manager can call upon to help meet institutional investors' needs. This ranges from the breadth of asset classes and strategies, through to the intellectual capital that a manager can deploy to help create genuinely diversified and dynamic portfolios - an increasingly attractive feature in today's demanding environment.
The crisis has also highlighted the importance of having well-developed infrastructure in place to support investors across market cycles. Investors and their advisers, having seen how easily a weak infrastructure can buckle in times of market stress, are rightly much more demanding in this regard. Clearly, putting in place robust processes, systems and teams comes at a cost and investors need be confident that their provider has the scope to achieve the necessary economies of scale without compromising service and performance.
At first glance, scale and risk management might seem unlikely bedfellows. After all, scale implies standardisation, while rigorous risk management requires detailed analysis of the specifics of a given risk position. In reality, modern investment technology allows asset managers to overcome this paradox. Nowadays, there are powerful systems that can analyse data on an industrial scale and allow investment teams to analyse portfolios down to the individual security level.
The key is to have the right people to make that scale work for investors. In practice, it means results are interpreted in a real-world setting, with the aim of ensuring that each risk position is deliberate, diversified and appropriately scaled. The crisis has also highlighted that risk management should be practised on a comprehensive basis, covering areas such as collateral and counterparty risk, but also the management of all-important liquidity risk. Mitigating each of these aspects effectively requires critical mass - be it in terms of being able to command access to liquidity in times of crisis, or having the necessary in-house expertise. Furthermore, only scale allows the continuous investment that is essential for ensuring pro-active risk management.
Nowhere is this aspect of scale more apparent than in the management of ‘alternative' asset classes. As alternatives rapidly move into the mainstream, the spotlight is firmly on the solidity of underlying infrastructure and the associated risk management. This emphasis has been compounded by a number of high-profile instances of fraud and failing liquidity and risk management. Each of these incidents shows that - contrary to the widely held pre-crisis view - successful long-term management of alternatives needs be underpinned by a robust platform.
We firmly believe that, while demonstrating a specialist ‘boutique' mind-set to alternative investments is an essential prerequisite, it alone is not sufficient. Investors should only consider investing with providers that can clearly demonstrate that they operate within a robust operational framework and have a strong and independent due-diligence and risk-oversight function. In today's complex and rapidly changing market environment this necessarily implies an efficient use of scale.
As already mentioned, the need to seek greater capital efficiency means that clients will increasingly expect their providers to deliver benefits of scale. This is most evident in the context of passive investing, where efficient beta exposure through index portfolios or exchange-traded funds can be optimised through having the requisite scale.
Yet, we believe it is also an important consideration with regards to alpha generation. As investors' risk budgets have to go further, we see an increased drive to make the most of that budget through, for instance, barbelling - combining efficient beta exposure with high alpha allocations. Generating these high levels of alpha is best done by relatively small and close-knit teams able to implement their best ideas and take meaningful positions, be they in equities, fixed income or alternative asset classes, on either an unconstrained or absolute-return basis. Offering these specialist teams the support of a well-developed infrastructure, for instance in the area of risk management, can increase the scope for alpha generation, provided it endorses the teams' freedom to capitalise on their alpha-generating skills.
One area that exemplifies this point is the use of scale to help foster debate and information flow between those alpha generators. Asset managers that are able to share information efficiently are in a better position to consistently generate risk-adjusted performance for their clients, whether it is equity and fixed-income teams sharing views on the creditworthiness of financials or quantitative and fundamental-investment teams discussing the euro-zone crisis. The key, however, is that this goes hand-in-hand with devolved accountability, to ensure that teams retain the liberty to implement their individual views.
Using scale appropriately also entails that individual teams are in a position to maintain a strict discipline around capacity management, thereby ensuring alpha generation is not compromised by over-commitment.
Each of the advantages outlined show how, regardless of asset class, scale can now be put to work to the benefit for clients by enhancing performance and assuring prudent risk management. However, as investors look beyond individual asset classes towards wholesale solutions for their specific goals, the challenge is now to combine scale with bespoke tailoring. The answer lies in combining the explicit recognition that the liability profile of each pension fund or insurer is unique, with the scale necessary to create efficiencies in terms of asset allocation expertise, liability and derivatives management know-how and the range of building blocks used.
Through innovative and flexible implementation, managers can then put in place an effective journey map to help clients meet their specific outcomes.
The future of scale
The use of scale will continue to evolve and increase in line with institutional investors' changing demands, touching areas as diverse as corporate governance and trading.
Specifically, as corporate governance and social responsibility move up the agenda, scale is becoming an increasingly important consideration, as managers need to have the necessary resource and clout to conduct meaningful engagement on behalf of their clients.
We also expect the re-ordering of the capital markets that is currently under way to be a driver of scale. In particular, regulatory changes are reducing the liquidity available in capital markets. In response, asset managers have to develop their trading and transition-management capabilities and find alternative routes of sourcing capital for their clients, all of which requires scale.
However, regardless of the area to which scale is applied, it is essential that scale is viewed not as an end in itself but, rather, as a tool to help clients achieve their specific outcomes more swiftly and effectively.
Charles Prideaux, is head of EMEA institutional business at BlackRock